International Trade Theory and Policy
by Steven M. Suranovic

Trade 95-3

Equivalence of an Import Tariff with a (Domestic Consumption Tax + Production Subsidy)

We begin by demonstrating the effects of a consumption tax and a production subsidy applied simultaneously by a small importing country. Then, we will show why the net effects are identical to an import tariff applied in the same setting and at the same rate.

We depict the initial equilibrium in the adjoining diagram. The free trade price is given by PFT. The domestic supply is S1 and domestic demand is D1 which determines imports in free trade as D1 - S1 (the red line).

When a specific consumption tax "t" the consumer price increases by the amount of the tax to PC. Because free trade is maintained, the producer's price would remain at PFT,. The increase in the consumer price reduces domestic demand to D2.

When a specific production subsidy "s" is implemented the producer price will rise by the amount of the tax to PP, but it will not affect the conumption price. As long as the production subsidy and the consumption tax are set at the same value (i.e., t = s), which we will assume, the new producer price will equal the new consumer price. (i.e., PC = PP).

The effect of the production subsidy and the consumption tax together is to lower imports from D1 - S1 (the red line) to D2 - S2.

The combined welfare effects of the production subsidy and consumption tax are shown in the Table below. The letters refer to the area in the previous graph. Red letters indicate losses while black letters indicate gains.

Static Welfare Effects of a
Production Subsidy + Consumption Tax

  Importing Country
Consumer Surplus - (a + b + c + d)
Producer Surplus + a
Tax Revenue
+ (a + b + c)
Subsidy Cost
- (a + b)
Govt. Revenue + c
National Welfare - (b + d)

Consumers suffer a loss in surplus because the price they pay rises by the amount of the consumption tax.

Producers gain in terms of producer surplus. The production subsidy raises the price producers receive by the amount of the subsidy, which in turn stimulates an increase in output.

The government receives tax revenue from the consumption tax but must pay out money for the production subsidy. However, since the subsidy and tax rates are assumed identical and since consumption exceeds production (because the country is an importer of the product) the revenue inflow exceeds the outflow. Thus, the net effect is a gain in revenue for the government.

In the end, the cost to consumers exceeds the sum of the benefits accruing to producers and the government, thus, the net national welfare effect of the two policies is negative.

Notice that these effects are identical to the effects of a tariff applied by a small importing country if the tariff is set at the same rate as the production subsidy or the consumption tax. (See page 90-11 for a comparison). If a specific tariff "t", of the same size as the subsidy and tax, were applied, the domestic price would rise to PP = PFT + t. Domestic producers, who are not charged the tariff, would experience an increase in their price to PP. The consumer price would also rise to PP. This means that the producer and consumer welfare effects would be identical to the case of a production subsidy/consumption tax. The government would only collect a tax on the imported commodities, which implies tariff revenue given by (c). This is exactly equal to the net revenue collected by the government from the production subsidy and consumption tax combined. The net national welfare losses to the economy in both cases are represented by the sum of the production efficiency loss (b) and the consumption efficiency loss (d).

International Trade Theory and Policy - Chapter 95-3: Last Updated on 10/17/02